Question

4. Given that productivity shocks are exogenous according to RBC theory,

what is it that real business cycle models need to explain?

Answer 1

Real business-cycle theory (RBC theory) is a class of new classical macroeconomics models in which business-cycle fluctuations to a large extent can be accounted for by real shocks.Real business cycle generally assumes that shocks to productivity leads to fluctuations in the economy. Productivity shocks play a central role in real business cycle as an exogenous impulse to macroeconomic activity. A technology shock is the kind resulting from a technogical development that affects productivity.

The main proposition of the real business cycle model:

• Real-business-cycle theory assumes that the market is undergoing variations in its ability to turn inputs into products and that these technical fluctuations trigger changes in outputs and employment. This theory also describes recessions as cycles of decline in technology.
• Recessions are the result of excessively strained monetary policy, just as booms are the result of too-easy monetary policy.
• Real business cycle models state that macroeconomic fluctuations in the economy can be largely explained by technological shocks and changes in productivity.
• These changes in technological growth affect the decisions of firms on investment and workers (labour supply). Hence changes in output can be traced to microeconomic and supply-side factors.
• Real business cycle models either completely reject or play down the role of aggregate demand in influencing the economic cycle.
• Real business cycle models suggest that government intervention to influence demand in the economy us generally counterproductive and the optimal policy is to concentrate on supply-side reforms which help the economy to be more efficient and flexible.

RBC theory views cycle as arising in frictionless, perfectly competitive economies with generally complete markets subject to real shocks. RBC models demonstrate that, even in such environments, cycles can arise through the reactions of optimizing agents to real disturbances, such as random changes in technology or productivity.